Inflating Away the National Debt

Can governments simply use inflation to make their national debts disappear?

That’s the subject of a new working paper by Jens Hilscher, Alon Raviv, and Ricardo Reis, who used real-world data to see how effective that inflation might be in reducing the real value of a government’s outstanding liabilities. Here’s the abstract of the paper:

We propose and implement a method that provides quantitative estimates of the extent to which higher- than-expected inflation can lower the real value of outstanding government debt. Looking forward, we derive a formula for the debt burden that relies on detailed information about debt maturity and claimholders, and that uses option prices to construct risk-adjusted probability distributions for inflation at different horizons. The estimates suggest that it is unlikely that inflation will lower the US fiscal burden significantly, and that the effect of higher inflation is modest for plausible counterfactuals. If instead inflation is combined with financial repression that ex post extends the maturity of the debt, then the reduction in value can be significant.

Their principal finding is that, by itself, boosting the rate of inflation in a nation would have only a modest effect in lowering the real level of its national debt.

But that changes if a policy of higher inflation is combined with financial repression, wherein governments force private citizens and firms to lend money to the government, often at capped interest rates, while restricting their ability to take or invest their funds outside of the country. Investopedia describes some of the features that financial repression would likely include:

Caps or ceilings on interest rates

Government ownership or control of domestic banks and financial institutions

Creation or maintenance of a captive domestic market for government debt

Restrictions on entry to the financial industry

Directing credit to certain industries

So what would be the reward for a government to implement these kinds of policies? Hilscher, Raiv, and Reis quantify the potential results for the United States in an earlier, ungated version of their working paper:

Applying it to the United States in 2012, we estimate that the effects of higher inflation on the fiscal burden are modest. A more promising route to inflate away the public debt is to use financial repression, and we estimate that a decade of repression combined with inflation could wipe out almost half of the debt.

Through August 1, 2014, the total public debt outstanding for the United States was nearly $17.7 trillion. By combining higher inflation with financial repression to extend the effective maturity dates for money being loaned to the federal government, U.S. elected officials could cut the inflation-adjusted value of the national debt by 50 percent in just 10 years by fully adopting the policies outlined in Hilscher, Raviv, and Reis’s working paper.

In fact, if you look just at U.S. history since the financial crisis of 2008, you can find that most of these elements have already been put into place, from legislation like Dodd-Frank that restricts entry into the financial industry and like FATCA, which imposes new capital controls on the financial accounts of American citizens who live or do business outside of the United States, the direction of credit to the politically favored green energy and education industries, the government’s takeover of the student loan industry, and even the newly created MyRA “savings” program, which is little more than a channel for boosting the sales of long-term, low-yielding U.S. Treasuries by targeting low-income earners.

In the end, the problem of national debt isn’t the debt so much as it is what governments do to get out of the massive debts they rack up. If that’s not a price are willing to commit yourself or your children and grandchildren to pay, then keeping the national government from racking up so much debt in the first place ought to be a major priority for you.

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